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http://ssrn.com/abstract=199332
 
 

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Option Prices with Uncertain Fundamentals: Theory and Evidence on the Dynamics of Implied Volatilities


Alexander David


University of Calgary - Haskayne School of Business

Pietro Veronesi


University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

November 2000

CRSP Working Paper No. 485; FEDS Working Paper No. 1999-47

Abstract:     
In an imcomplete information model, we show that investors' uncertainty about the drift of a firm's fundamentals affects option prices through its affect on stock volatility and the covariance between returns and volatility. We provide an option pricing formula using Fourier Transforms. Filtered investor beliefs from real earnings growth are able to explain time-variation in implied volatility, the skewness premium, and the kurtosis premium embedded in option prices. Option-implied investor beliefs vacillated rapidly before the crash of 1987, remained highly uncertain for a year afterwards, and except for the 1990-91 recession, strongly favored rapid growth until 1996. Model fits to cross-sectional option prices are almost comparable to Heston's (1993) stochastic volatility model while hedging and variance forecasting performance is superior.

Number of Pages in PDF File: 64

JEL Classification: G12, G13, G14, D84

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Date posted: February 17, 2000  

Suggested Citation

David, Alexander and Veronesi, Pietro, Option Prices with Uncertain Fundamentals: Theory and Evidence on the Dynamics of Implied Volatilities (November 2000). CRSP Working Paper No. 485; FEDS Working Paper No. 1999-47. Available at SSRN: http://ssrn.com/abstract=199332 or http://dx.doi.org/10.2139/ssrn.199332

Contact Information

Alexander David (Contact Author)
University of Calgary - Haskayne School of Business ( email )
2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada
Pietro Veronesi
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-6348 (Phone)
773-702-0458 (Fax)
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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